Calibrated Manufacturing Case Study: Maximizing Profit through Expansion and Price Increase

Current Operating Data

Calibrated manufacturing makes an electronic component that is in great demand. The component sells for $20 each. Calibrated’s current capacity is 10,000 units per week.  For the last few months, however, the company has been receiving new orders at a rate of 14,000 units per week, and now has a substantial backlog. The company expects this order rate to continue, if it maintains price.

Sales Revenue $200,000

Variable Costs $100,000

Fixed Costs $80,000

Pretax Profit $20,000

For each incremental addition of 500 units of output weekly, Calibrated would need to purchase new equipment that would add $1,500 to weekly fixed costs. No other fixed costs would become incremental for this price change. Labor costs currently account for half of all variable costs.  Additional hires, however, are expected to be more costly than the average of current employees because of their lower productivity.

Although new hires are paid (wages + fringe benefits) only 80% of the current average, they can produce only two-thirds as much output per hour.  Consequently, labor costs for additional output with new hires is 20% higher than the current average.

Calibrated is debating whether to keep its current price and expand to meet the demand or to raise its price to reduce demand somewhat before deciding whether or not to expand.

1.How much would Calibrated’s weekly profits increase if it expanded to meet the entire amount of its current excess demand?

$CM (before) = $20-$10 per unit

New Variable Cost = $5 + ($5 x 1.2) = $11

$CM (after expansion) = $20 - $11 = $9 per unit

Increase in Total Contribution Margin (9 x 4000)= $36,000

Less Increase in Fixed Costs (8 x 1500)  -$12,000

Net Profit Contribution from Expansion $24,000

2. Prepare an analysis of a 10% price increase

oCalculate the break-even sales quantity (percent and units)

oCalculate the new $ contribution margin per unit

%CM = 9/20 = .45 or 45%

Basic $BE = -10/45 + 10 = -.10/55 = -.18.18 or -18.2%

Unit BE = -.1818 x 14,000 = -2548 units

Notice that I have used a baseline of 14,000 units since this represents the demand at current price.  You must also consider that a reduction in sales of this size enables the company to avoid five increases in semi-fixed costs (at $1,500 each) because 2500 fewer units of capacity would be required.  To calculate the new dollar contribution margin per unit.  It is $11: the new price, $22, minus the relevant variable costs, $11.

Unit BE = -2548 + -5 x $1,500/11 = -3230 units

Unit BE = -2548 + -6 x $1,500/11 = -3,366 units

3. What risks might be to Calibrated of increasing price to maximize profit?

4. What risks might there be to Calibrated of expanding output rather than reducing demand through a price increase.